The Difference Between Private and Public Debts - Case Study Example

Private and Public Debts: The Difference [ID Much is made in the media and among pundits about public debt, relating it to private debt.We hear that the United States government, were it a business, would be failing, or that like a household, it has to cut spending. These metaphors, though well-meaning, are highly misleading. The difference between public debt held by countries and private debt held by countries is qualitative: They are philosophically, practically, economically and normatively different. In Reinhart and Rogoffs This Time is Different notes, “[V]irtually all countries have defaulted on external debt at least once” (2009, p. 86). Consider the way that the British defaulted on war debts to the Americans (Mead, 2002). Most of the industrialized nations have defaulted on debt. Spain defaulted thirteen times over four centuries! Indeed, “French finance minister Abbe Terray... even opined that governments should default at least once every hundred years”... (Reinhart and Rogoff, 2009, p. 87). This indicates two things about public debt. First of all: Default on public debt is nearly omnipresent. This is because the debtors in question are themselves likely to be permanent institutions, based on the logic of the European nation-state system, and are borrowing from other states, who are also permanent institutions. Yet the defaulting rate on private loans is nowhere near 100%. Second, enforcement of public debt is highly politicized and uneven. Britains war debts were excused; Germanys werent (Mead, 2002). Most private debt is treated relatively evenly: One is loaned money and one has to pay it back, no matter who one is. We can also see from this that this uneven enforcement can give countries an incentive to default that is not present in the domestic economy. It is hard to enforce across country lines. And, of course, the access to enforcement varies. If the US defaulted on a loan to China, they could use their military power to prevent enforcement. If Nigeria defaulted on a loan to the United States, the matter would be entirely different. Another difference is that, while private debt is based on an individual familys economic situations or the micro-economy of a region, public debt is often based on entire market institutions and trends ( Reinhart and Rogoff, 2009, p. 87-89). Capital inflows or growth often precede defaults, due to large amounts of debt being taken on due to the belief that “this time will be different”. Individual families or companies do not tend to behave this way. Countries do. Since 1800, public debt defaults have exploded due to “the combination of the development of international capital markets and the emergence of new nation-states”. Entirely new people do not appear and disappear in the private economic system, but civil wars, secessions, revolutions and post-colonialist movements can lead to countries changing their borders, composition or identity. And international capital markets, based on things like currency speculation, tend not to affect individual debts but do affect public debts. Another difference is that debt reschedulings may not be partial defaults in the private economy, but are in the public one ( Reinhart and Rogoff, 2009, p. 90-92). This is because with debt reschedulings, investors are often paid with “illiquid assets” that are not guaranteed to pay off and do not do so in general. This would be like someone trying to pay off their credit card debts in barter: Unheard of in the private market, common in the public one. One of the major differences between private and public debt is that who is responsible for private debt is well-accepted. But with public debt, one has to question whether or not the government can legitimately ask the rest of the country to pay. If theres a regime change, does the prior regime and its members have to pay, or the current one? What if its a corrupt dictator? What if the regime is a foreign puppet regime? Consider the case of Indonesia. “For example, the "country" of Indonesia didnt borrow; its US-backed rulers did. The debt, which is huge, is held by about 200 people (probably less): the dictators family and their cronies. So those people have no right to ask for debt forgiveness — and, in fact, dont have to. Their wealth (much of it in Western banks) probably suffices to cover the debt, and more” (Chomsky, 2000). Many Third World countries racked up immense debt underneath horrible conditions, or thanks to the toxic legacy of European colonialism (Chomsky, 2000; Pogge). This is not just a matter of economic policy, but of law. As Pogge puts it in “Poverty and Human Rights”, Are the rich countries violating human rights when they, in collaboration with Southern elites, impose a global institutional order under which, foreseeably and avoidably, hundreds of millions cannot attain “a standard of living adequate for the health and well-being of himself and of his family, including food, clothing, housing and medical care” (Universal Declaration of Human Rights §25)? The Declaration itself makes quite clear that they do when it proclaims that “everyone is entitled to a social and international order in which the rights and freedoms set forth in this Declaration can be fully realized” ... The existing international institutional order fails this test...[I]t fosters corrupt and oppressive government in the poorer countries by recognizing any person or group holding effective power — regardless of how they acquired or exercise it — as entitled to sell the country’s resources and to dispose of the proceeds of such sales, to borrow in the country’s name and thereby to impose debt service obligations upon it, to sign treaties on the country’s behalf and thus to bind its present and future population, and to use state revenues to buy the means of internal repression. The importance of this difference cannot be exaggerated. In the private economy, it is massively difficult to amass a lot of debt to aggrandize you, then transfer it onto yourself. But in the public economy, corrupt elites and leadership can ring up a massive debt, then force a new generation of people who received no or little benefit (Pogge; Chomsky, 2000). It gets worse when you consider collusion with the debtors themselves: “More generally, bad leadership, civil wars, and widespread corruption in the developing countries are not wholly homegrown, but strongly encouraged by the existing international rules and extreme inequalities. The rulers and officials of these countries have vastly more to gain from catering to the interests of wealthy foreign governments, corporations, and tourists than from meeting the basic needs of their impoverished compatriots” (Pogge). This would be the equivalent of a private lender suborning fraud! First World companies and political elites and governments beholden to those companies can coordinate with Third World elites to rob the country, and often do. This is robbery, not debt. Not only is there a perverse incentive for elites to ring up massive debts that they will not pay, but foreign debtors often have another perverse incentive to loan money: It can be used to secure control over an economy. “[G]overments of states have less control over their economies... [T]he organisation of credit in the world economy has been revolutionized... Governments have no control over these innovations... Taxation... is another big area where states have lost control, where their spending power is beyond their own control, determined by the whims of foreign bondholders...” (Strange, 1998, p. 180). Foreign debtors can loan enough to be able to control economic and political decisions of debtor countries. They can use interest rates on their loans to prevent economic stimulus packages. They can veto social investments they dont like such as socialized medicine. It gets worse. IMF policies not only encouraged but required lending to and borrowing for many Third World countries (Chomsky, 2000!) People are forced to lend. This is because of the competing functions of the IMF, which is nominally designed to improve the economies of nations but has begun to act as enforcer for private companies and the First World (Chomsky, 2000; Palast, 2002; Stiglitz, 2003). The IMF can force a World Bank loan then link failure to repay to a number of illegal political contingencies (Palast, 2002). All of these systems are interlinked and lead to a highly sophisticated system of robbery, nothing like the lending of the private market. There is also a degree of subjectivity as to who owns the products bought by the debt and who benefits from the debt. In a private debt, these issues dont come up: If I take out a loan and waste it on luxury goods, I am on the hook for it. But if one generation takes out a number of loans under the reasoning that a Pinochet-style “free market” is beneficial for growth, then the economy tanks, who should pay (Palast, 2004)? This is what makes identifying this fraud so difficult. If someone steals an ATM card and rings up $2000 in an ATM in Madrid when the card owner lives in Texas, this is clearly fraud. But what about building a skyscraper? What about beautifying the part of the city the elite lives in, under the (publicly stated) reasoning that doing so will attract external investment? What about the idea of “trickle down” economics? Is a pay raise for Congressmen paid from the debt a justified expenditure? These issues do not characterize private debt. The money that is financed by the debt is also often connected to international currency markets, which further changes the matter. Theres also the obvious issues of the principles of debt. The very reason that interest rates are justified under a free market is because there is risk. [T]his response assumes the capitalist principle. According to this principle, if I borrow money from you, use it to buy a Mercedes and a mansion, send most of the money to a bank in Zurich, and then you come and ask me to repay the loan, Im not supposed to be able to say: "Sorry, I dont want to pay you back, take it from the folks in the downtown slums". And youre not supposed to say: "I got the high yields from this risky investment, but now that the borrower doesnt want to pay it back, the risk should be transferred to other folks in my country through socialisation of the debt". Thats the capitalist principle. It would suffice to largely eliminate the debt. Of course, that principle is unacceptable to the rich and powerful, who prefer the operative "capitalist" principle of socialising risk and cost. So the risk is shifted to northern taxpayers (via the IMF) and the costs are transferred to poor peasants in Indonesia, who never borrowed the money....The argument that "their country" borrowed the money so they are responsible surpasses cynicism and need not be considered. In fact, it doesnt even stand up under international law. When the US conquered Cuba in 1898 to prevent it from liberating itself from Spain (what is called "the liberation of Cuba from Spanish rule"), it cancelled Cubas debt to Spain on the reasonable grounds that the debt had been forced on the people of Cuba without their consent. That doctrine, called "odious debt", was later upheld in international arbitration, with US initiative...[I]f this principle were applied to Third World debt, it would mostly disappear. But that would mean that the capitalist principle would have to be observed: borrowers have the responsibility, lenders take the risk. And that plainly wont do, when the concentration of power makes it possible to socialise cost and risk (Chomsky, 2000). The state has been turned into an instrument of debt collection in the private economy, true. And this undermines to no small extent the logic and wisdom of private debt. But bankruptcy and other reforms have made it so the state protects both debtor and lender alike. Inflation is controlled, for example, to try to make it so workers and debtors can pay back loans with money that is less valuable than when they took it, but not so much so that it acts to discourage lending. Yet there is no such balance. The IMF uses both political, economic and military coercion to insure repayment of debts. There are very few political counter-measures that benefit the debtor: The system is a lender and investor-favoring system (Herman, 2002). Then consider that public debt is often an investment into the future (Zepezauer, 2004). Extreme debt is obviously problematic, but some debt is used to finance long-term investments. While it would be ideal for families to be free from debt, and it would be irresponsible for them to get into debt to help the economy, this makes sense for countries. Putting some bonds into the economy provides a safe investment opportunity and helps to provide for infrastructure developments. The difference between public and private debt could not be more different. Another obvious difference is that, to pay for loaned money, governments can print money, issue bonds, change interest rates, increase taxation, etc. Yet private citizens cannot do so. Other political factors also change the behavior of loans. The 2008 presidential election deepened the subprime crisis, which did change the private debt situation somewhat but certainl altered the public debt situation massively (Reinhart and Rogoff, 2009). Then there is the factor of “financial contagion”: If First World private economies change, Third World loans are frozen and repayment arrangements changed. This makes defaults far more common and understandable: International loans are unreliable for both lender and debtor. Then consider that, while private debt is often good for people and defaulting is bad, for public debt, defaulting is often better than paying back the loan. Palast notes that the only country who recovered from the need to have an IMF assistance program was Botswana, which refused IMF aid; Argentina, similarly, got out of its situation through working with Venezuela and defying the IMF. Yet another factor is that domestic economic policy in another country can cripple a society. “[T]he sharp rise in interest rates in the US, under the late Carter/Reagan policies of a form of "structural adjustment" here, undertaken with no concern, of course, for the fact that this would impose a crushing burden on Third World debtors, as it did” (Chomsky, 2000). Finally, public debt is dependent not just on economic success and wealth, but public order, regime type and stability, etc. (Bungenberg et al, 2009; Beim and Calomiris, 2001, pg. 44). A lender to a private individual can be a bank, but in the developed or sophisticated financial system providing to public good, mortgage companies, insurance companies like AIG, economic universities and planning institutions, etc. are involved. The public and private economies are qualitatively different. A private business that defaults on a loan is not likely to have been forced into taking that loan by a powerful international market organization backed by governmental and military forces, is not likely to have transferred that money to their investors then be able to transfer the risk onto a nearby slum that didnt even know about the loan, etc. For this reason, bankruptcies need to be tougher for them. But public debts need to be more forgiving. Policy regarding debt must be different. If forgiving odious debt or putting a debt cap was instituted, the Third World might be able to pull itself from poverty and into industrialization. The differences are clear, and the implications obvious: Public debt needs different political and economic treatment and enforcement. List of References Beim D. & C. Calomiris, Emerging Financial Markets, 2001, McGraw-Hill. Bungenberg, M., Meessen, K., Puttler, A., 2009 Economic Law as an Economic Good: Its Rule Function and Its Tool Function in the Competition of Systems, Sellier: Europe. Chinn, M.D., Ito, H., “CAPITAL ACCOUNT LIBERALIZATION, INSTITUTIONS AND FINANCIAL DEVELOPMENT: CROSS COUNTRY EVIDENCE”, NBER Working Papers Series, Working Paper 8967. Chomsky, N., Bello, W., Brutus, D, 2001, A Letter to the US Congress. http://www.thirdworldtraveler.com/Globalization/Letter_Congress_DGE.html Chomsky, N, May 24 2000, Noam Chomsky: The capitalist principle and the Third World debt, Green Left, http://www.greenleft.org.au/node/22291 Crane, A., Hutchinson, M., 8 November 2010, “Beware Bonds With High Risk and Low Protection”, Reuters. Daneher, K., 2001, Democratizing the Global Economy, Common Courage Press. Herman, E, 2002, “Sophistry of Imperialism”, Z Magazine. Krasa, S., Sharma, T., Villamil, A. P., 7 August 2003, “The Effect of Enforcement on Firm Finance”, University of Illinois, http://www.econ.uiuc.edu/~skrasa/debt.pdf Palast, G, 2004, The Best Democracy Money Can Buy. Reinhart, C.M. and K.S., Rogoff, 2009, This time is different, Princeton University Press: New Jersey. Stiglitz, J, 2003, Globalization and its discontents, W.W. Norton & Company: New York. Strange, S., 1998, Mad money, Manchester University Press. Pogge, T, “Poverty and Human Rights”, http://www2.ohchr.org/english/issues/poverty/expert/docs/Thomas_Pogge_Summary.pdf Zepezauer, M., 2004, Take the rich off welfare, Read More